Shares of Commonwealth Bank of Australia (ASX: CBA) surged 1.9% higher on Friday in a relief rally sparked by data showing weak business spending which could suggest further interest rate cuts are around the corner.
Even though the stock has now risen 5% since hitting a recent low of $81 to trade at $85.09, some investors are no doubt seeing now as a perfect time to buy the stock. Indeed, it remains 12% shy of its 52-week and all-time high (at $96.69) and further interest rate cuts could act as a catalyst for greater growth in loans, as well as even lower bad debt charges.
However, there are also a number of key reasons investors should approach the bank with extreme caution. In a recent two-part series, I highlighted some of the key headwinds facing Australia's banking industry, including recent scandals that could ruin reputations, the booming housing industry as well as tougher capital restrictions that will likely be imposed on the banks. You can read 'Part One' and 'Part Two' of that series by clicking here, and here.
The bank's valuation is also reason for concern. The bank now trades on a price-earnings ratio of 15.2x estimated earnings for the 2015 financial year, which is well above its moving five-year average (represented by the dotted line in the chart below).
Source: Yahoo! Finance and Commonwealth Bank of Australia annual reports
A more accurate measure for determining a bank's value is the use of the price/book ratio, which measures the share price relative to the accountants' value of its assets, less liabilities. As it stands, the bank trades on a price/book ratio of 2.8 times its 2014 net assets which is, again, well above its historical and five-year moving averages.
Source: Yahoo! Finance and Commonwealth Bank of Australia annual reports
So why has the stock become so expensive?
Each of Australia's big four banks have benefited enormously from the low interest rate environment. The nation's cash rate has fallen from 7.25 percent in 2008 to a record low of 2 percent currently, which has led to a period of record profitability.
While that in itself is reason enough to bid a stock higher in price, investors have taken it to an extreme level in their chase for solid, fully franked dividends to offset the otherwise low returns from "risk-free" investments, including government bonds or term deposits. As a result of this insatiable hunger for fully franked dividends, the stock has been pushed to unprecedented heights, with some pundits even suggesting it will climb above the $100 mark in the near future (up 17.5% from today's price).
However, although the bank has increased its dividends per share, its actual dividend yield has fallen as a result of this soaring share price. That means that investors who purchase shares today are being offered an inferior return (4.96%) in the form of dividends than those investors who have bought their shares in years gone by (for example, the 6.75% offered in the 2012 financial year):
Source: Yahoo! Finance and Commonwealth Bank annual reports
Time to sell
Although Commonwealth Bank could have further to run in the near-term, it has become overpriced by almost every measure. With the stock's yield having lost most of its appeal, together with the key risks now facing the banking industry (and the Australian economy as a whole), investors would be advised to steer clear of the Bank altogether.
